Organizing Principles of Business Valuation: The Grapes of Value
After nearly ten years in the business of valuing companies — as a securities analyst at an investment banking firm from 1978 to 1982, and during Mercer Capital’s early years — I became a member of the American Society of Appraisers in 1987. During those formative years of my business valuation career, I gradually became aware that consideration of six underlying financial, economic, logical, and psychological principles provide a solid basis for considering valuation questions and issues.
Each of these principles provides a way of looking at the world from a valuation perspective. The combination of the principles, or rather, their integration, provides a logical and consistent framework within which to examine business valuation questions and issues.
These principles need a name for this article to make sense, so let’s call them the “Organizing Principles of Business Valuation,” or, for short, the “Organizing Principles.” The acronym, GRAPES, provides a convenient word to help organize and remember the Organizing Principles, which we will sometimes refer to here (with a tip of the hat to John Steinbeck) as the GRAPES of Value. Here they are used in the manner in which they describe the world we live in, and below they are discussed as principles.
We live in a world that needs to be viewed, from a valuation perspective as being described in terms of the Grapes of Value:
G rowth world
R isk/reward world
A lternative investment world
P resent value world
E xpectational world
S ane, rational and consistent world
The real world may not always conform to all of the Organizing Principles. More concretely, specific situations in the real world may not conform or appear to conform. But there is a congruence between theses principles and the business appraisers’ hypothetical world of fair market value. And specific situations in the real world can often be reconciled to the Organizing Principles when we discover which principle has been “violated.”
The Organizing Principles provide a mental checklist and form the basis for addressing nearly every business valuation issue. They are, I believe, descriptive of the underlying behavior of public securities markets which, as we will see, form the comparative basis for the valuation of most businesses. The principles also provide an implicit set of standards for testing the rationality or reasonableness of valuation positions advanced by appraisers.
I have used these principles actively for many years, both as an organizing tool for valuation thinking and as a review tool for our own work and that of others.
I didn’t consciously articulate the Organizing Principles prior to joining the American Society of Appraisers, but they were firmly established in my thinking by the time I began writing my earliest articles addressed to the business appraisal profession in 1988 and 1989:
- “Not So Random Thoughts Regarding the Business of Business Appraisal,” BUSINESS VALUATION REVIEW, June 1988, pp. 62-63. This article, which was written in response to an earlier article by John Emory, ASA (who prepares the Emory Restricted Stock Studies).
- “Issues in Recurring Valuations: Methodological Comparisons from Year-to-Year,” A Letter to the Editor to the BUSINESS VALUATION REVIEW, December 1988, pp. 171-173.
- “The Adjusted Capital Asset Pricing Model for Developing Capitalization Rates: An Extension of Previous ‘Build-Up’ Methodologies Based Upon the Capital Asset Pricing Model,” BUSINESS VALUATION REVIEW, December 1989, pp. 147-156. All of the Organizing Principles were present in this article.
In the following sections, we will discuss each of the Organizing Principles. At the conclusion of the article we will see that while each principle is separate, it is their integration that provides for solid understanding of valuation issues.
G – the principle of GROWTH and time
We live in a growing world. Evolution and growth are an integral part of nature, economies, and the business world. Investors look at the world, the economy, and individual businesses with an underlying assumption that growth will occur. Implicitly, growth occurs over time, so we call the growth principle the Principle of Growth and Time. There can, of course, be negative aspects to economic, industrial or business growth. But we live in an economic world where growth is viewed, on balance, as good.
Other things being equal, a growing business is more valuable than a similar business that is not growing. Other things being equal, a business that is growing more rapidly than another, similar business is more valuable than the slower-growing entity. The Growth Principle suggests, in nonmathematical terms, that there is an underlying relationship over time between growth and value.
Appraisers need to focus on relevant aspects of growth as they address appraisal questions — ranging from the world economy, to the national economy, to the regional economy, to a particular industry, to a particular company, or to the facts and circumstances influencing the ownership of a particular business interest.
The principle of growth is often linked, as we will see, to the principle of Expectation. But they are not the same principle.
R – the principle of RISK and REWARD
Life is full of risks and rewards. In the context of life, there is a relationship between risk and reward that has been known for many centuries — long before the development of modern financial and valuation theory.
This relationship is evidenced by the Biblical “Parable of the Talents” (Matthew 25:14-30). In this New Testament parable, there are three servants who, upon the departure of the master, were given stewardship responsibility for resources. One steward received five talents (currency-equivalent units), another two talents, and the third, one talent.
The first servant invested the five talents and grew the master’s stake until his return. The second servant invested the two talents and similarly grew the master’s stake. The third steward was fearful of loss and buried his talent until the master’s return.
When, the master returned, the first servant rendered his report and told the master of his gain. The second servant reported similarly. And the third steward gave the original talent back to the master. The master was pleased with the work of the first two servants. But the third servant, who was not a good steward, was rebuked. The master took away the talent and gave it to the first steward who had handled his responsibilities well.
The “Parable of the Talents” is summarized here, not to make a theological statement (if, indeed I could), but to illustrate that the concept of the relationship between risk and reward has been in existence for thousands of years.
The Principle of Risk/Reward can be summed up in the words of an immortal unknown: “No risk, no blue chips!” This principle is integrated within the Present Value Principle via the factor known as the discount rate, or required rate of return. It is also embodied, implicitly or explicitly when we employ the Principle of Alternative Investments.
A – the principle of ALTERNATIVE investments
We live in an alternative investment world. This Principle of Alternative Investments suggests that investments are made in the context of making choices between or among competing alternatives. When investors make investment decisions, there are almost always choices that must be made. In the public securities markets investors ask questions like: “Should we buy Compaq or Dell or Gateway stock?” “Should we buy large cap or small cap stocks?” “Should we buy stocks or bonds or real estate?”
Already, we can see that by combining principles, we can begin to describe the way the world works. For example, by combining aspects of the Principle of Risk and Reward and the Principle of Alternative Investments, investors make asset allocation decisions regarding their investments.
The Principle of Alternative Investments also is suggestive of the concept of opportunity costs. When resources are deployed to acquire one asset, they are not available to purchase another.
In the valuation of private businesses and business interests, the Principle of Alternative Investments leads to comparing private businesses with similar businesses whose shares (or debt) are publicly traded. When Revenue Ruling 59-60 directs appraisers to make comparisons of a subject enterprise with the securities of similar companies with active public markets, the Principle of Alternative Investments is being invoked.
The public securities markets are massive and active and provide liquid investment alternatives to investments in many privately owned businesses. Business appraisers need to have a thorough working knowledge of these markets in order to provide realistic appraisals of private business interests.
Virtually every appraisal of a minority interest of a private business begins with (or develops as an interim step) a hypothetical value for the company’s shares “as if freely traded.” In other words, we develop value indications at the marketable minority interest level prior to the application of appropriate marketability discounts.
Perhaps the biggest single shortcoming in the business appraisal profession today is the overall level of understanding of the public securities markets and their relationships to private company values. A number of appraisers have experience as securities analysts with investment banking or money management firms. Others have pursued the Chartered Financial Analyst designation to learn about the public markets. And still others have pursued learning about the public markets through personal study and personal experience.
Unfortunately, far too many appraisers who have entered the business in recent years (or who have been here for years) have, at best, a rudimentary knowledge of how the public securities markets work. While I am jumping the gun on the Principle of Expectations, let me illustrate with a concrete example.
In a recent case, I encountered a nationally-known appraiser (who is an ASA, a CPA, and a CFA — with no securities industry experience). This gentleman wrote a report in which he used guideline companies whose earnings in the current year (trailing 12-months) were significantly down from the prior year(s), but whose estimated earnings for the coming year were much higher. He calculated trailing 12-month earnings multiples for the guideline groups which were inflated relative to the multiples for expected earnings (which he did not provide in his report). He then applied these inflated earnings to his subject companies’ trailing 12-month earnings (which, by the way, were expected to be flat or down in nearly every case).
Having demonstrated his lack of understanding of how the public securities work, he nevertheless seemed offended when I criticized his use of the guideline company method and stated that his valuation indications were inflated. A future issue of E-Law will deal with this issue and illustrate the impact of his mistake.
The point of this discussion of the Principle of Alternative Investments is that the principle requires (assumes) that business appraisers are familiar with the public securities markets and capable of making reasonable comparisons of the public and private markets and drawing reasonable valuation inferences.
P — the PRESENT value principle
Stated in its most simple form, the Present Value Principle says that a dollar today is worth more than a dollar tomorrow. Alternatively, a dollar tomorrow is worth less than a dollar today. Present value is really an intuitive concept that even children understand. Ask any child whether it is better to get a toy today or to get the same toy next week!
When we talk about present value, we really talk about four aspects of investments:
- Investments have duration. They exist over time. We forego consumption today (or make a choice among competing alternatives) in order to gain the benefit of the investment over its duration.
- We expect investments to grow in value.
- Investments are not all the same in terms of their cash flows to the investor.
- And investments have different risk characteristics.
The Present Value Principle enables us to compare investments of differing durations, growth expectations, cash flows, and risks. Present value calculations enable us to express the present value of different investments in terms of dollars today and therefore provide a means to make investment or valuation decisions.
Business appraisers use a model known as the Gordon Dividend Growth Model to express the value of a business today. Technically, this model says the following:
Value today is the present value of all expected future dividends (cash flows), beginning with the next period from today, divided by (or capitalized by) a discount rate (k) minus the expected growth rate of the Dividend. This model is reflective of an income approach to valuation, and is often expressed as follows:
This model reflects a single period income capitalization valuation method commonly employed by business appraisers. The appropriate cash flow might be the net income, the pre-tax earnings, or some measure of cash flow that is expected to be achieved and from which income can grow. The discount rate is developed by comparisons with relevant alternative investments, and the expected growth rate of the cash flow is estimated by the appraiser. Valuation methods flow from present value concepts.
The purpose of our discussion today, however, is simply to note that we live in a present value world. Business appraisers must be intimately familiar with present value concepts and be able to articulate valuation facts and circumstances in a present value context. That is why my HP 12-C calculator travels with me everywhere I go. I’m lost without it in this present value world.
E – the principle of EXPECTATIONS
The example of the Gordon Dividend Growth Model makes it clear that today’s value is a function of tomorrow’s expected cash flows, not yesterday’s performance. This is a simple but often overlooked aspect of valuation.
Appraisers routinely examine a company’s historical performance and develop estimates of earning power based on that history. The earnings capitalized may be an average of recent years’ earnings, or a weighted average of those earnings. In the alternative, an appraiser might capitalize the current year’s earnings or make a specific forecast of expected earnings for next year. The purpose of all historical analysis, however, is to develop reasonable expectations for the future of a business.
We noted the expectational nature of the public securities markets in the example above. The Gordon Model could not be clearer about the expectational nature of valuation. Nevertheless, the Principle of Expectations is one of the most difficult for beginning (and even experienced) appraisers, particularly those with limited public securities market backgrounds, to embrace in practice.
A sidebar to this brief discussion of the role of expectations in valuation relates to the use of unrealistic expectations. One of the most frequent problems seen in appraisal reports today is the use of projected earnings that bear little or no resemblance to those of the past. These projections often lack any explanation of how the rose-colored glasses, through which they view a business, reflect realistic expectations for the future of a business. The projection phenomena just described is so common that it has been given a name — “hockey-stick projections.”
S – the principle of SANITY (and Rationality and Consistency)
The Principle of Sanity might have been that of Rationality had another “R” fit into my acronym of GRAPES. But sanity will do.
When I speak to appraisers about the nature of the public securities markets, many are quick to explain to me the many (apparent or real) exceptions to sane, rational or consistent investment behavior. However, while the exceptions are always interesting, what we are discussing is the underlying rationality of the markets operating as a whole.
Many an unthinking investor has been taken to the proverbial cleaners by the investment pitch that “seemed almost too good to be true.” It probably was too good to be true. Lying beneath the surface of this comment are implicit comparisons with alternative investments that are sane, rational, or consistent with normal expectations.
Some appraisers are also quick to point out that the markets themselves sometimes behave abnormally or, seemingly, irrationally.
I make observations about the comments of appraisers for a specific reason. Too many of us get caught up in the exceptions and miss the big picture that is played out in the public securities markets. If we can understand the underlying rationality or sanity of the markets, we then have a basis to explain or to understand the seeming exceptions.
The Principle of Sanity should be applied to appraisers as well as markets. Revenue Ruling 59-60, in the paragraph prior to the enumeration of the famous factors that are listed in nearly every appraisal report, suggests that appraisers employ three additional factors — common sense, informed judgment and reasonableness. We call the famous eight factors the Basic Eight factors of valuation. We call the less well-known factors from RR 59-60 the
Critical Three factors of valuation.
The Principle of Sanity (among others) suggests that appraisers need to study the markets they use as valuation reference points (comparables or guidelines). It also suggests that valuation conclusions should be sane, rational, consistent and reasonable.
We employ “tests of reasonableness” in Mercer Capital valuation reports to compare our conclusions with relevant alternative investments or to explain why we believe our conclusions are reasonable. Other appraisers call the same process that of using “sanity checks.” Readers of appraisal reports should expect such “proof” of the sanity of the conclusions found in those reports (and often, at critical steps along the way as critical valuation decisions are made).
The importance of the Organizing Principles of Business Valuation summarized by GRAPES lies in their integrated consideration by appraisers. A couple of brief examples:
G-rowth. Revenue Ruling 59-60 and common sense tell us to examine the “outlook for the future” of the business, i.e., for its earnings and cash flows.
R-isk/Reward. We examine the history and nature of a business to discern its particular risk characteristics. These characteristics are used in the overall assessment of riskiness, which, as seen in the Gordon model above, impacts value through the discount rate (R) selected.
A-lternative Investments. We compare subject private companies to publicly trade securities because the later represent realistic alternative investments for hypothetical buyers. Conceptually, when we develop a value indication at the “as if freely traded” level, we are developing a hypothetical value. Since the interest is not marketable like the selected guidelines, we then adjust up or down the levels of value hierarchy to develop valuation conclusions at the appropriate level of value.
P-resent Value. The common denominator for comparing alternative or competing investments is found in present value analysis. Value for a business today is, conceptually, the present value of the expected future cash flows of the enterprise discounted to the present at an appropriate discount rate. Value for an illiquid interest in a business is, conceptually, the expected future cash flows attributable to the interest discounted to the present at an appropriate discount rate.
E-xpectations. The market price securities in companies based on expected future benefits. The baseline valuation question is not: “What have you done for me in the past?” Nor is it even: “What can I (reasonably) expect that you will do for me tomorrow?” Valuation is a forward looking or expectational science/philosophy/art/psychology/religion.
S-anity. There is an underlying sanity and rationality and consistency to the public markets that is sometimes difficult to discern. Appraisers who focus on exceptions in the marketplace rather than on underlying logic and rationality are prone to major swings of overvaluation or undervaluation.
Appraisers who have a grasp on the GRAPES of Value have a leg up in the process of developing reasonable valuation conclusions. Attorneys and other advisors to business owners who use the GRAPES of Value as a framework in which to discuss valuation questions can get to bottom-line issues more rapidly and effectively.
(Reprinted from Mercer Capital’s E-Law Newsletter, 99-11, July 22, 1999)